IND-AS: Accounting For Embedded Leases

Many entities enter into arrangements for sale, purchase or other service arrangements, that do not take the legal form of lease; but nevertheless they convey a right to use an asset such as an item of property, plant or equipment for an agreed period of time in return for a payment or series of payments. The current Indian GAAP does not contain any specific guidance requiring the identification of leases contained in a transaction structured as sale, purchase or rendering of service. In the absence of such guidance, entities typically do not identify leases contained in such arrangements; rather, such transactions are generally accounted based on their legal form. The application of Ind-AS will require entities to carefully examine the terms of an arrangement to determine whether it is, or contains, a lease. Appendix C to Ind-AS 17 provides the following two criteria, which if met, will indicate the existence of a lease:(a) Fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset), and(b) The arrangement conveys a right to use the assetThese two criteria are not straight forward and require a careful analysis in each case.

Dependence On A Specific AssetInd-AS 17 applies only to an arrangement in which there is a ‘right to use an asset’, and therefore an arrangement will not contain a lease unless it depends on the use of a specific asset. If a specific asset needed to meet the purchaser’s requirements is either explicitly or implicitly specified in the arrangement, then the fulfilment of the arrangement is dependent on the use of that specific asset.

An arrangement may contain a lease when the contract explicitly requires a specific asset to be used. The arrangement may also contain a lease when no asset is specified but it is not economically feasible or practicable for the supplier to use an alternative asset, for example when the asset has been developed specifically to meet the purchaser’s needs or when the supplier owns only one suitable asset. On the other hand, when a specific asset is explicitly identified by the arrangement, but the seller has the right and the ability to provide the relevant goods using other assets not specified in the agreement, the arrangement will not contain a lease. An implicit requirement relates to the assessment of economic circumstances of the supplier and is likely to require more information about the supplier than is usually reflected in the contract concerned.

Conveys A Right To Use The AssetOnce a specific asset is identified, there must then be an assessment as to whether there is a right of use, which is essentially a right to control the use of the underlying asset. Appendix C to Ind-AS 17 refers to three conditions that can indicate such a right of use exists, of which only one needs to be met. These three conditions are:

(a) The purchaser has the ability or right to operate the asset or direct others to operate the asset in a manner it determines while obtaining or controlling more than an insignificant amount of the output or other utility of the asset.(b) The purchaser has the ability or right to control physical access to the underlying asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset.(c) Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement. Further, the price that the purchaser will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.

The first two conditions are relatively straight-forward, but sometimes challenging judgments may be required. The “right to operate or direct others to operate” the asset relates to the ability to make decisions about when and how the asset will be used. This can be evidenced through the ability to hire or replace the operator of the asset or by specifying significant operating policies and procedures, although it does not require any involvement in the day-to-day management and operations. The effect of these powers must in substance be to reduce the role of the supplier to that of an agent working to the instructions of the purchaser.

The right to control physical access is similar to the previous condition and looks at the ability to stop others from using or accessing the asset for their needs, or restricting the ability of the supplier to move or use the asset as it deems appropriate. Where the specific asset is identified in the agreement, this right will often exist. For example, Entity Z has outsourced its storage of confidential data. The data storage is controlled by means of a computer system owned by the supplier and located at its premises, which was developed specifically to meet Z’s requirements. The contract with Z takes 70% of the capacity with the other 30% being used to supply services to two other entities. Z has the right to approve or reject new customers for services that involve the use of the computer system. The asset is customized to Z’s needs and therefore cannot be “interchanged” easily. Z controls physical access to that asset as a result of its right to approve or reject new customers for services that involves the use of the computer system. Also 70% would certainly be considered more than an insignificant amount of the capacity. Thus, this arrangement would contain a lease.

The phrase “more than an insignificant amount” is not defined. It will be a matter of judgment in each case as to what percentage of output is “more than insignificant.” For example, 30% may not generally be considered insignificant whereas 5% might be regarded as insignificant. This will also require an assessment of the asset’s total capacity, which again may not necessarily be specified in the contract, although this may have been taken into account in the negotiations.

The third condition would require the contracted arrangements to be compared with the asset’s capacity and an assessment of the feasibility of other parties taking some of the output. If an entity in an arrangement takes nearly all of the capacity, it is unlikely that other customers could be obtained by the supplier as it will not be economical to have “small” contracts.

Arrangements that provide for the purchaser to take all or substantially all of the output from a specific asset may not convey the right to use the asset if the purchaser is essentially paying an arm’s length price for a product or service rather than paying for a right to use the specific asset. This is the case if the price that the purchaser pays is contractually fixed per unit of output or at the current market price as of the time of delivery of the output. When the arrangement involves a single purchaser taking substantially all of the output from a specific asset other than at market price and the price varies other than in response to market price changes, the variability is regarded as indicating that payment is being made for the right to use the asset rather than for the actual use of or output from the asset. This will therefore require a thorough analysis of all the pricing arrangements within relevant contracts.

The “current market price per unit of output” means that the cost is solely a market price for the output, without any other variation, for example, ‘market price per unit plus per cent change in price of natural gas’ would not be the current market price per unit of the output of the asset. Ind-AS 17 does not provide any specific guidance on the meaning of “fixed price per unit of output,” giving rise to many application issues. For example, arrangement in which unit price is subject to step pricing as explained in table 1 below may not be treated as “fixed price unit of output” because it could be structured in a way to reimburse a fixed capacity charge and a variable amount per unit of output.

Table 1: Step pricing

No. of units

Price per unit

0 to 100,000

INR160

100,001 to 200,000

INR150

200,001 to 300,000

INR155

Above 300,000

INR142

However, if the total volumes and total price for a contract are fixed (pre-determined at the inception of the contract), then regardless of how the pricing for the individual units occurs, the arrangement is likely to meet the exemption for fixed prices, because the price per unit is fixed on a total contract basis. Also, fixed price exemption criteria may be met if different prices are agreed at different points in time. For example, A Ltd. agrees to buy all of the electricity generated by a wind farm. A Ltd. pays 10 per MW generated in the summer months and 14 per MW generated in winter months. This arrangement meets the exemption for fixed prices.

Contracts Commonly Identified As LeaseAn embedded lease may exist in sale/purchase/service contracts entered by entities in any industry. Given below are some contracts that are most susceptible to a lease classification under Ind AS 17:· Outsourcing arrangements, e.g., the outsourcing of an entity’s data processing, storage or other functions such as manufacturing

· Exclusive sale/purchase/supply contracts

· Suppliers of network capacity that provide purchasers with rights to capacity, e.g., in the telecommunications industry

· Power purchase agreement or other take-or-pay contracts requiring the purchaser to make specified payments regardless of whether it takes delivery of the contracted products or services

Accounting And Business ImpactIf, based on criteria discussed above, an entity determines that an arrangement is, or contains, a lease, the subsequent accounting for the lease element will be covered under Ind-AS 17 Leases. For example, an entity determines whether a lease is an operating lease or a finance lease based on Ind-AS 17 criteria. Other elements of the arrangement must be accounted for in accordance with the appropriate standards.

If leases are identified, this would significantly impact the financial position and performance of both the service provider and the customer. A simple example of this would be the case of a company which exclusively provides subcontracting services to another company and assets are exclusively identified for that purpose. In such case this arrangement could well be determined to be a finance lease which will lead to the entity derecognizing its assets completely and recognizing lease payments receivable instead. The asset and finance lease liability is recognised by the customer.

Apart from the impact on financial statements, such accounting may also have significant business implications for both the lessor and lessee, for example, compliance with debt covenants, measurement of EBITDA, presentation of revenue and cost numbers and ability to raise further finance.

Given that the criteria for determining a lease are largely qualitative, implementing Appendix C to Ind-AS 17 may require significant judgment, time and effort. The information needed to assess the existence of a lease is generally contained both in the purchase/sale contracts as well as procured from external sources. Therefore, a process needs to be established to evaluate leases in such contracts. Very often, it is most beneficial to have evaluations done before entering such contracts so that undesirable accounting consequences can be avoided if possible.